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Investing In High Dividend Yield Stocks

Investing In High Dividend Yield Stocks

Jan. 12, 2016

Jan. 12, 2016

The extremely low interest rate environment combined with slow economic growth and rising market volatility have contributed to the erosion of returns from traditional fixed income investments, especially over the last few years. In the search for yield, dividend investing has re-gained investor focus. This article analyses the potential of high dividend-paying stocks, which can be efficiently accessed through Eurex’s lately introduced STOXX® Global Select Dividend 100 Index Futures and Options.

According to Bloomberg Intelligence, since 2003, dividend weighted funds accounted for roughly 60 percent of all U.S.-domiciled Smart Beta ETF flows. Of the USD 400 billion Smart Beta ETF assets, more than half are allocated to dividend-oriented funds. In Europe the trend is even more pronounced, with two thirds of Smart Beta assets allocated to dividend funds. STOXX® based ETFs are leading this development and have attracted almost half of the assets in all European dividend based funds (over EUR 4 billion in assets).

High dividend-paying stocks can be attractive for many reasons. Dividends tend to be a strong indication of a company’s future prospects and performance. These are usually steady, mature businesses, such as utilities, telecoms or financial sector companies, with stable cash flows, less volatile and with a sustainable dividend policy. Finally, dividend distributions tend to be robust despite economic downturns and their reinvestment over longer time horizons has historically produced exceptional investment results.

The (grey) shaded area in Figure 1 shows the proportion of dividends paid out (and reinvested) by the STOXX® Global Select Dividend companies as depicted by the difference between the net total return and the price indices since the index has been calculated (the index is detailed in the following sections).

Figure 1 - STOXX® Global Select Dividend 100 with dividends (blue) and without dividends (pink) - in thousands

Historical outperformance
A dividend strategy consisting of buying companies that pay stable, above market, sustainable dividends has proved itself as a long term consistently profitable strategy over market cycles. Given the quality of these equities, it comes as no surprise that they have demonstrated the ability to outperform the broader market. Figure 2 shows that, over the last 15 years, the EURO STOXX® Select Dividend 30 Index and the STOXX® Global Select Dividend 100 Index outperformed their benchmarks by more than 45 and 80 percent, respectively. This is equivalent to an average yearly outperformance of 2 and 4 percent, respectively.

At the same time, the outperformance has been achieved without adding additional volatility or by substantially deviating from the market cap-weighted broad-based benchmark. The high correlation coefficients of 0.92 and 0.98 against the STOXX® Global and the EURO STOXX® Indices, respectively, indicate a proven track record without introducing dramatically different periodic return volatility.

Figure 2 - STOXX® Select Dividend Index: characteristics and performance (in thousands)

Dividend yield
Simply looking at dividend yields can be misleading despite historical outperformance of high dividend yield strategies. In constructing portfolios, investors cannot merely target high dividend yielding stocks under the assumption that these companies are in a position to sustain those yields. It is important to look at the fundamentals and if they indicate a sustainable high dividend yield.

Dividends indicate fundamentals
In general, stable, above average dividends should signal strong fundamentals. Any equity strategy is a good expected investment if the stocks are relatively cheap and of good quality. Typical valuation metrics for relatively undervalued stocks are earnings before interest and taxes to total enterprise value – EBIT/TEV – and the price to earnings – P/E – ratios. We compare the above measures for the Select Dividend sub-indices against their respective broad-based benchmarks. As Table 1 shows, the high dividend yield subsample, as selected by the STOXX® methodology is generally “cheaper” than the broader market, as indicated by the selected metrics, namely EBIT/TEV and P/E ratios. Select Dividend indices have “cheaper” valuations for the global portfolio, as well as for each of the individual regions of Asia/Pacific, Europe and North America.

Another important aspect of equity valuation is quality. Ideally, the quality of the selected stocks, as measured by return on equity and return on assets, should be higher than that of the broader market. From Table 1 we can see that the Select Dividend subsets, with no exception, show better returns. Among the three regions, valuations in Europe are particularly attractive based on the value and quality metrics. The European Central Bank's 60-billion-euro-a-month quantitative easing program and the euro's depreciation against the dollar, among other things, had a positive effect on the equity markets across Europe resulting in these attractive valuations.

Table 1 - Comparison of valuation metrics for select dividend indices against their respective broad-based benchmark

Dividends indicate value
One reason for attractive valuations and consistent historical outperformance of high dividend yield stocks versus the broader market is that weighting towards dividend yield would routinely capture the value factor. This comes as no surprise, since dividends have long been a way to calculate value. From the classic dividend discount model to corporate finance theory, dividends are the building block in a company’s value.

Understanding the risk
We identified high yield stocks as value companies with stable and consistent profits able to systematically deliver above average risk adjusted returns over market cycles. Nonetheless, a stock's dividend yield is driven by the company’s performance (i.e. profitability, earnings, cash flow) which in turn depends on the prevailing market environment and company-specific factors. Despite dividend strategies being an attractive alternative to traditionally safe, but low return, fixed income investments, dividends are still attached to equities. In times of distress, even companies with consistent dividend payments can lose share value, cut dividend payments or go out of business.

STOXX® Global – investment tools to capture yield
Launched in 2007, the STOXX® Global Select Dividend 100 Index is the first global index to measure the performance of high dividend yielding stocks worldwide. It tracks the 40 highest dividend-yielding stocks in North America as well as the 30 highest dividend yielding stocks in Europe and in Asia/Pacific, respectively. The indices are price-weighted with a weighting factor based on the dividend yield.
To be eligible for inclusion in the STOXX® Global Select Dividend 100 Index, a company must have a positive historical five-year dividend-per-share growth rate and a dividend-to-earnings-per-share ratio of less than or equal to 60 percent in Europe and the North America, 80 percent in Asia/Pacific the current year, or be a previous component.

Basic facts on STOXX® Select Dividend regional indices

1) In deviation from the approach for  European STOXX indices where Eurex calculates the FSP at noon, for the STOXX Global the approach similar to the MSCI Global indices is used, where Eurex takes the closing index level of the 3rd Friday of the maturity/expiration month

The weight of individual components in the STOXX® Global Select Dividend 100 Index is restricted to 15 percent in order to prevent the index from being dominated by single high dividend paying stocks.

Futures & Options at Eurex Exchange
The STOXX® Global Select Dividend 100 Index serves as a performance benchmark for investors focusing on dividend yield. Whether investors are looking to obtain and manage exposure to the high dividend yielding segments or hedge an existing equity portfolio, the newly listed futures & options should help achieve these goals, with all the usual benefits of a CCP product.

Contract specifications - STOXX® Global Select Dividend 100 Index

Liquidity providers for STOXX® Select Dividend derivatives on Eurex Exchange
A number of Market Makers and brokers are supporting the Eurex products by providing onscreen liquidity and facilitating Block Trades or other off-book trades.

Conclusion
In the search for yield, dividend investing has regained investor focus. Despite consistent money inflow into high yielding strategies in recent years, valuations, especially in Europe, are still very attractive. While rates in the U.S. are expected to go up in the near future, in Europe the forecasts still point to near zero interest rates, which make dividend strategies an attractive alternative to low risk / low return fixed interest investments. The STOXX® Global Select Dividend 100 Index is the first index to measure the performance of a global high dividend yielding portfolio. Whether investors are looking to obtain and manage exposure to the high dividend yielding segments or hedge an existing equity portfolio, the newly listed futures & options should help achieve these goals, with all the usual benefits of a CCP product.

 

Nicolae Raulet, Global Product Research and Development, Eurex Frankfurt AG

For more information, please visit eurexchange.com or contact nicolae.raulet@eurexchange.com

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